Issue 27 - January 2009
Tax notes    

The Hong Kong Inland Revenue Ordinance (IRO) charges Salaries Tax on an individual in respect of income arising in or derived from Hong Kong from an office or employment and also from services rendered in Hong Kong.

Income from employment includes Share Awards if they are provided as a reward for services.

Salaries Tax treatment of Share Awards
Share Awards granted to employees are taxable benefits forming part of the employee's employment income which is subject to Salaries Tax if those awards are granted as a reward for services. Whilst Share Award plans vary in detail the two main points to be addressed in determining the Salaries Tax treatment of such awards are:

When does the benefit accrue to the employee?
Section 11D(b) of the IRO provides that for Salaries Tax purposes income accrues to a person when he becomes entitled to claim payment. The Hong Kong Inland Revenue Department (IRD) considers that the phrase "entitled to claim payment" in the context of Share Award schemes means "entitled to ownership of the shares". The IRD will usually adopt one of two approaches in assessing Share Awards benefits. These are:

	an "Upfront" approach which taxes the benefit when the employer grants an award to the employee; and
	a "Back End" approach which taxes the employee when the shares actually vest to the employee free of any conditions.

"Upfront" approach
The award is assessed to tax upfront at the time of grant of the award by the employer. The award 
granted may or may not be subject to restrictions. The restrictions envisaged here are typically restrictions on the right to sell the share award within a certain period of time. It is only after the expiry of the restrictions that the employee would have full economic right to the shares. Other than this restriction, the employee's name would be entered in the shareholders' register, he would be entitled to vote in general meeting, receive dividends, etc. In short, the employee has all the rights of a normal shareholder, except the freedom to sell during the restriction period. Most importantly, at the end of the restriction period, normally little needs to be done to "vest" the shares in the employee.

"Back End" approach
This approach applies where share awards are granted subject to conditions before the shares are vested in the employees and the shares are subject to forfeiture if the conditions are not fulfilled, or if the employee resigns or is dismissed. The most common vesting conditions include completion of a period of employment with the same employer/group or the employer attaining a certain level of financial or operational results, etc. Before the fulfilment of these conditions, the shares are simply not vested in the employee – even if the shares are allotted and held by a trustee.

Unlike the upfront approach the employee normally "does not have the rights of a shareholder, he is not registered as a shareholder and he is not allowed to vote or to receive dividends". It is only at the end of the vesting period that the employee would receive his shares together with dividends or bonus shares distributed during the vesting period.

In these situations if the employee was to receive dividends on the unvested share awards during the vesting period the IRD considers the dividends so received are subject to Salaries Tax as a benefit from employment as the employee is entitled to the shares only at the end of the vesting period. Thus even if the "dividends" received during the vesting period relate to unvested shares in a non Hong Kong company they are taxable if they are a reward under a Hong Kong employment or for services rendered in Hong  Kong.

The IRD considers that at the time of grant the employee receives only a promise with respect to the shares. It is only when the shares are vested free of any restrictions that the employee is considered to have received the benefit which is then chargeable to tax at the end of the vesting period i.e. at the "Back End" of the vesting period.

Market value
Whether the share awards are assessed on an "Upfront" or "Back End" basis the taxable benefit is 
assessed based on the market value of the shares. This is calculated at the time of grant of the award in the Upfront situation and at the time of vesting of the shares in the Back End situation.

It should be noted that the gain to be assessed is a notional one, as chargeability occurs whether or not the employee sells the shares acquired under the award. Even if no sale of shares takes place and the employee retains the shares as an investment the employee will be subject to Salaries Tax on the notional gain at the taxable date.

The market value for quoted shares is readily ascertainable. However, if the share award relates to shares in a private company the employer can negotiate with the IRD with a view to agreeing the valuation of the shares on the date of grant or vesting as appropriate.

Share awards which are assessed on an "Upfront" basis may contain restrictions on the employee's right such as restriction on sale during a certain period. Such restrictions can have an impact in determining the market value i.e. the amount which the person might reasonably expect to obtain from a sale in the open market. Where there are such restrictions in place a valuation exercise should be undertaken based on the facts of the particular case, but in the Board of Review case D120/05, a 25% discount was allowed to reflect the five year restriction period on the sale of shares. The IRD will often offer a discount of 5% per annum for similar restrictions.

Sale of shares
Hong Kong does not have a Capital Gains Tax and any gains assessed on the subsequent sale of the shares obtained as a result of participation in a share award scheme are not taxable in Hong Kong.

Hong Kong and non Hong Kong source employment
Another factor to be considered is whether the employee has a Hong Kong source or non Hong Kong source employment during the vesting period.

Where an individual has a Hong Kong source employment he is subject to Salaries Tax under Section 
8(1) IRO on all his assessable income even if he spends a significant period of time outside Hong Kong.

Where an individual has a non Hong Kong source employment he will be able to apportion his income on the basis of the days spent in Hong Kong and days spent outside Hong Kong, commonly known as a time claim. Only the income relating to services in respect of days spent in Hong Kong will be subject to Salaries Tax.

Where an employee is eligible for a time claim his share awards will be subject to apportionment. Where the "Upfront" approach applies the share awards will be subject to Salaries Tax in the year of grant and be subject to apportionment based on the days spent in Hong Kong in that Year of Assessment. Where the "Back End" approach applies the share awards will be subject to Salaries Tax in the year in which they vest and be subject to apportionment based on the days spent in that Year of Assessment.
 

Chargeability
The charging provisions apply regardless of whether the individual is still employed by the employer which granted the award on the date of the taxable event.

Change of employment
In the case of awards which are subject to a vesting period and taxed on a "Back End" basis, the share awards will usually lapse if the employee changes employment and in these cases these will be no taxable benefit.

However, in the case of employees working for multinational groups, there will be cases where an employee, who has share awards which are subject to a vesting period and thus taxed on a "Back End" basis, does not forfeit the shares awards when he ceases employment in Hong Kong.

For example, an individual working for a Hong Kong company in a multinational group may have been granted a share award in respect of shares in an offshore holding company. The awards are taxed on a "Back End" basis as they are subject to a three year vesting period during which the employee must continue to work for the group. If the individual is transferred to a group company in, say, Singapore during the vesting period, the share awards will not lapse.

In this case, the employee will be subject to Salaries Tax when the shares vest even though he is not employed in Hong Kong at that time.

The taxable benefit when the award vests is calculated by reference to the market value on the date of vesting in the normal way. The individual is then subject to Salaries Tax on that benefit in the Year of Assessment in which the individual ceased to be employed in Hong Kong, rather than the Year of Assessment in which the vesting takes place.

This can have important implications for employees who change the location of their employment within a group. In particular this can affect employees who are granted awards whilst they are working in Hong Kong which vest after they leave Hong Kong. It will also impact individuals who are granted awards before they arrive in Hong Kong to take up employment and the awards vest whilst the individuals are in employment in the same group in Hong Kong.

In the case of awards which are taxed on the "Upfront" basis the employee is usually in the employment of the company making the award at the time of grant and therefore this does not normally cause any 
problems.

Year of commencement and cessation
Employees arriving in Hong Kong with share awards granted by their employer before they came to Hong Kong should seek detailed advice regarding the Salaries Tax implications of any vesting period.

Similarly, employees who are granted awards subject to a vesting period whilst in Hong Kong and who 
leave Hong Kong during the vesting period but do not forfeit their shares as a result of their relocation 
should seek detailed advice regarding the Salaries Tax treatment of their benefits.

Summary
Share Award Schemes vary greatly in their detail. Accordingly, detailed advice should be sought regarding the Salaries Tax implications of the individual scheme.

In particular, detailed advice should be sought where

	employees take up employment in Hong Kong and have unvested awards which were granted before they arrive in Hong Kong; and
	employees are granted share awards whilst in employment in Hong Kong which vest after the employee departs from Hong Kong.

"Upfront" versus "Back End" - A comparison of the Salaries Tax treatment under the two approaches is set out below:

Contact Information

Paul Chow
T  +852 2218 3188
E  paul.chow@gthk.com.hk

Gary James
T  +852 2218 3137
E  gary.james@gthk.com.hk

David Southwood
T  +852 2218 3103
E  david.southwood@gthk.com.hk

Brenda Cheung
T  +852 2218 3136
E  brenda.cheung@gthk.com.hk

Mary Ho
T  +852 2218 3040
E  mary.ho@gthk.com.hk

Daisy Ip
T  +852 2218 3168
E  daisy.ip@gthk.com.hk

Winnie Tsui
T  +852 2218 3280
E  winnie.wy.tsui@gthk.com.hk

About Tax notes
Tax notes are issued in summary form exclusively for the information of clients and staff of Grant Thornton and should not be used or relied upon as a substitute for detailed advice. Accordingly Grant Thornton accepts no responsibility for any loss that occurs to any party who acts on the information contained herein without further consultation with ourselves.

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